Risk Management

Budgeting for Risk Management Unknowns

Dealing with the unknown is a key part of budgeting and planning for corporate risk management departments, an industry veteran explains.
David KatzApril 20, 2016

Risk managers are “comfortable dealing with the unknown,” says Gordon Adams. That’s a good thing, he adds, because they’re dealing with it all the time.

Indeed, the unknown is a permanent aspect of the budgeting and planning process of corporate risk management and insurance departments, according to Adams, who a few months ago took on the job of managing property-casualty risks for the clients of Servco Pacific Insurance, an insurance brokerage based on the West Coast.

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The risk management executive, who previously was chief risk officer for Tri-Marine International, a global tuna fishing company, and has more than 40 years of experience in various insurance industry roles, says the uncertainty is greatest in one of two cost “silos” built into the budgets of risk management departments. (Adams spoke with CFO at last week’s Risk and Insurance Management Conference in San Diego.)

Gordon Adams

Gordon Adams

The first silo includes payroll and other relatively fixed risk management expenses. “Those are pretty predictable, and you know where you are” in terms of budgeting for them, Adams says, noting that directors of risk management are generally provided with guidelines developed by CFOs, controllers, and treasurers. The guidelines contain ranges of possible salary increases, turnover, and chargebacks of risk costs to different departments.

“You get that in computer form and you can just start working on [budgeting] it like any other department,” he adds.

Less fixed — but still within familiar parameters — are insurance costs incurred under existing, renewable coverage. Seasoned risk managers aware of whether property and casualty insurance markets are softening (getting cheaper) or hardening (getting costlier) can accordingly make adjustments to their current premiums and “get pretty close on the actual [budgeted] insurance costs” that the company will incur in its annual budget, he adds.

The unknowns crop up in the insurance silo when risk managers ponder whether their companies will need any new coverage, and, if they do, what’s it going to cost. If the company is launching new projects or product lines, or is about to embark on an acquisition, its insurance buyers must consider what potential losses it faces on those activities, according to Adams.

Further, if the extent of a risk is mostly unknown, so will be the amounts of coverage available. Insurance on the risks involved in the use of new technologies like driverless cars, for instance, can be extremely hard to come by, according to Adams. “Who’s going to insure them?” he asks. “You talk to the auto insurance companies and they say they have no statistics, no records. What happens if your software gets breached or you get hacked, which is a real possibility?”

In such cases, because insurers have no loss experience on which to base a reasonable price and develop profit expectations, they refuse to cover the risk, he adds.      

If there’s little or no insurance to be had on such exposures, corporate buyers may have to budget for large deductibles on their policies or set up self-insurance programs, the risk management executive says.  

That triggers another budgetary consideration: If the company will have to spend its own money on funding the risk (rather than buying insurance), should it set up a reserve fund or simply dole out company funds for losses as they occur?

At that point, the risk manager would normally negotiate those issues with the CFO, who could spell out in detail the new ventures the company is embarking on for the year and the risks they might entail, according to Adams.

Over the course of his career, Adams has observed that much of risk management budgeting and planning is fairly standardized. Budgeting usually begins 90 days from the end of a company’s either calendar year or fiscal year as part of its overall budget process.

The finance chief, controller, or corporate treasurer informs the risk manager at that point that the company will need information concerning its expected costs for insurance and for running the risk management. “Sometimes they will give you ground rules for how to put that information together, and a lot of times you’ll do it yourself,” he says, referring to the risk manager.

For example, if senior finance executives budget in a top-down way, they’ll provide the risk manager with an overall percentage hike for salaries and insurance costs, plus an increase based on the rate of inflation. If, on the other hand, the risk manager is tasked with developing his or her department’s own budget, “that becomes a little more granular because we have a little better angle on the insurance and department costs,” Adams says.

Further, risk managers may be in the position of negotiating their portion of budget cuts with the heads of other departments.

If, for instance, the department heads request a cumulative budget of $600 million, but the CFO says management is requesting $500 million, the department heads may have to come together and bargain for a total of $100 million in decreases. “It can be a very controlled process or a very … ground-up one,” he adds.